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Protecting Assets by Understanding Human Nature

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American businesses and business owners are among the prime targets for investment criminals, reckless financial advisers, and inept bunglers, all of whom can destroy millions of dollars in assets in a matter of weeks.  But businesspeople, like the rest of us, tend to minimize their vulnerability, believing that the victims of investment fraud are especially greedy, or gullible, or just plain stupid.  The truth is that all healthy humans —especially successful business people—are hardwired to fall for investment fraud, and only those who understand why can adequately protect themselves.  In this article we’ll briefly sketch that human wiring. 

Human nature

Advances in the science of human perception and decision-making have answered the question of why businesses and business owners lose so much each year to investment fraud.  It turns out that we are hardwired for it.  Psychologists call the culprits “cognitive biases.”  You can think of cognitive biases as the default settings of a healthy human brain; the way we tend to process information.  Let’s look at two biases that tend to lead us astray when we consider investments or advisers.

The optimism bias

Several studies have established the tendency of healthy humans to underestimate the likelihood of disastrous events.  We simply don’t believe that disaster—including financial disaster—will strike us.  It might strike other people, but not us. Psychologists call this belief the optimism bias.

The optimism bias is useful.  As pessimistic as we may be, the vast majority of us are optimistic enough to leave our homes each morning and venture into a world full of germs and crime and teenaged drivers.  Without an abiding sense that everything is going to be all right—that nothing too bad is going to happen to us today—we’d never leave home.  Yet, this same bias works against us in the investment context.  When we sit across from a charismatic investment adviser who makes a persuasive case for a particular investment, it never occurs to us that this person might be a criminal, that he or she might be financially desperate themselves and anxious to “borrow” just a little bit of our nest egg, or that he or she, despite the gift of gab, might be wholly incompetent.  Sure, we might be a little wary of someone we’ve never met before, but the adviser will soon put us at ease.

An accomplice of the optimism bias is our tendency to mistranslate charisma into character.  Let’s face it, some people just have it.  Think of a skilled politician who can make the person she is talking to feel like the only person in the room despite a crowd clamoring for her attention.  Well, just about every investment salesperson has that level of charisma.  The industry drives out those who don’t have it.  Every scamster or reckless adviser, therefore, will have a level of charisma that could talk a teenager out of his Xbox 360.  You’ll just naturally trust them.

But scientists have confirmed that charisma is more an inherited trait than a learned behavior.  Some people have it just like some people have red hair or green eyes. How wise would you feel saying that you trust your financial adviser because he has red hair and green eyes?  Not too wise, right?  Well, trusting a financial adviser because his manner and his eloquence naturally lead you to do so is no smarter than that.  Remember, charisma is no predictor of character.

How do we counter the optimism bias?  By remembering that we are always dealing with human beings.  And even the best humans make mistakes; you might say it’s one of our defining characteristics.  Some people have jobs in which their worst mistakes can do only minimal damage.  If a worker at the DMV types in your address wrong, it might cause you no end of hassle, but it won’t cost you your life savings.  When investment advisers and promoters make mistakes, though, it can cost you everything you’ve entrusted to them.  The wise business or business owner therefore puts charisma on the shelf as a given, and gets busy with a thorough due diligence investigation of the adviser or the investment opportunity.  Which brings us to our next cognitive bias.

The congruence bias

The Congruence Bias quickly settles on a theory to explain what we are experiencing.  And it turns out that we are stubbornly devoted to that theory.  Our tendency to accept information that confirms our first theory and to minimize conflicting information is called the congruence bias.  As with the optimism bias, it is enormously useful in most contexts, but absolutely deadly in the investment context. The congruence bias can lead us to believe that we are conducting a extraordinarily thorough due diligence investigation, when we are actually only setting a scam artist’s hook deeper.  

In a scandal in Bohemia, Sir Arthur Conan Doyle described the dangers of the congruence bias long before psychologists gave it a name.  Sherlock Holmes says to Dr. Watson, “It is a capital mistake to theorize before one has data.  Insensibly one begins to twist facts to suit theories instead of theories to suit facts.”  Holmes recognized that settling upon a theory too soon threatens to make us view every new fact in a light that makes it consistent with our theory.

And that’s just what the congruence bias does.

Our first theory when we listen to a charismatic investment adviser describe a profitable investment is that the adviser is who he appears to be and that the investment performs as described.  Legitimacy, therefore, becomes our first theory. Setting out to confirm that theory, we tend to view every fact we gather in a way that makes it consistent with our theory.  If a fact crops up that is wholly inconsistent with legitimacy, the congruence bias makes us minimize that fact and even consider it irrelevant.

The only cure to the congruence bias is adopting the proper initial theory.  If the 100 percent loss that comes with fraud is what we are trying to avoid, then fraud has to be our theory.  At Investor’s Watchdog, therefore, we adopt the theory that the person selling the investment is not what he or she seems and that the investment is a cleverly disguised fraud.  Pursuit of that theory leads us to resources that no one trying to confirm legitimacy would ever access.  If we cannot prove the fraud theory, we advise our clients that the investment is at least a legitimate attempt to earn a profit.  The investment might go up or might go down, but it is not a fraud from the inception.  How can an investigator looking to confirm legitimacy ever say the same?  He or she has not looked for the thing they are most afraid of.  The mental approach to the investigation means everything.

Conclusion

Hundreds of public and private pension funds have lost fortunes in the past five years to every brand of investment scheme you can imagine.  People wonder how that can be so when so many smart people work to keep the investments safe.  The answer lies mostly in the paragraphs above; very bright, highly educated due diligence professionals are skilled at business valuation but have insufficient understanding of cognitive biases and how they color their investigations.

The epidemic continues.  Businesses and business owners will lose several billion dollars to investment fraud this year, and more next year.  Brilliant investment consultants, an army of risk managers, and long lists of dos and don’ts from well-meaning consumer reporters cannot stop it from happening.  But businesspeople who understand why it happens can begin to turn the tide.  Training those who chose how the company invests excess cash is the proper starting place for businesses.  For business owners, incorporating an understanding of the cognitive biases into a thorough due diligence investigation is the way to begin.

All the regulators in the world could not stop this epidemic of investment fraud from beginning.  But an army of properly trained investors, both institutions and individuals, can protect themselves and help cleanse the investing landscape as no regulator can.

Pat Huddleston, a former SEC Enforcement Branch Chief, is the author of The Vigilant Investor, published by AMACOM Books (New York).  He serves as court-appointed receiver in SEC fraud cases, represents investors in securities litigation and arbitration, and leads Investor’s Watchdog LLC, a due diligence company.  He is a frequent guest on radio and television and has been quoted in the New York Times, the Wall Street Journal, the Financial Times, Newsweek, and Kiplinger’s Personal Finance, among other publications.